Keith Peterka – “Valuation Strategies for Early Stage Companies”

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Fair Value Measurements:
An Accountant’s Perspective
Presented by
Keith C. Peterka, CPA
CBIZ MHM, LLC
March 21, 2012
Today’s Discussion
 The Accountant’s Role in Fair Value Measurements
 SFAS 157 / ASC 820 “Fair Value” – What’s all the fuss??
 Mergers and Acquisitions: it’s a Fair Value World
2
The Accountant’s Role / Perspective
 Independence Rules
 GAAP is not a Four Letter Word, perhaps in some cases.
 Confidence
3
Fair Value Measurements:
What are they,
and why are they important?
4
Data on Funds Sought and Valuations
Source: Angelsoft, Inc.
5
Fair Value Measurements:
The Great Accounting Debate
 Fair value accounting continues to generate significant
controversy among preparers, financial statement
users, investors, auditors, regulators and even
Congress.
 Some have attributed at least part of the 2008
economic crisis on the application of fair value
accounting.
6
The Case SUPPORTING Fair Value :
 The current mixed attribute system is seriously flawed – it is too
complex and does not provide enough transparency to users of
financial statements.
 Current financial statements have become irrelevant to users –
most financial analysis is based on adjusting net income rather than
relying on it as a relevant measurement.
7
The Case AGAINST Fair Value
 Fair value accounting in many cases is based on a series of
subjective estimates and therefore may be less reliable
than historical cost.
 Fair-value accounting would require finance and accounting
personnel to develop new skills – many of these
departments are already overburdened by the increase in
corporate governance requirements – not to mention the
continuing stream of new and revised accounting
pronouncements.
8
The FASB’s Definition of Fair Value
SFAS 157 / ASC 820
SFAS 157 provides the following definition of “fair value”:
The price that would be received to sell an asset or
paid to transfer a liability in an orderly transaction
between market participants at the measurement
date.
9
The Game Changes
 This definition of fair value retains the exchange-price notion of fair
value. Fair value is based on the exit price – the price that would be
received to sell an asset or paid to transfer a liability, not the
transaction price or entry price – the price that was paid for the asset
or that was received to assume the liability.
 Conceptually, entry and exit prices are different. The exit price
concept is based on current expectations about the sale or transfer
price from the perspective of market participants.
 Under FAS 157, a fair value measurement should reflect all of the
assumptions that market participants would use in pricing an asset or
liability.
10
Market Participant Concept
• Fair Value is not the value specific to the reporting entity,
and it’s not the specific value to one market participant
whose risk assessment or specific synergies differ from other
market participants.
• Key considerations in developing market participant
assumptions may include the specific location, condition, and
other characteristics of the asset or liability (e.g., assumed
growth rates, whether certain synergies are available to all
market participants, and risk premium assumptions).
11
Valuation Techniques
SFAS 157/ASC 820 describes three approaches to
measuring the fair value of assets and liabilities:
• the Market Approach,
• the Income Approach, and
• the Cost Approach.
12
Choosing the Correct Valuation Method
Valuation techniques that are appropriate in the circumstances and for
which sufficient data are available shall be used to measure fair
value. In some cases, a single valuation technique will be appropriate.
In other cases, multiple valuation techniques will be appropriate. If
multiple valuation techniques are used to measure fair value, the
results shall be evaluated and weighted, as appropriate, considering
the reasonableness of the range indicated by those results.
– A fair value measurement is the point within that range that
is most representative of fair value in the circumstances.
13
Market Approach
The market approach uses prices and other relevant information
generated by market transactions involving identical or comparable
assets or liabilities (including a business).
For example, valuation techniques consistent with the market approach
often use market multiples derived from a set of comparables. Multiples
might lie in ranges with a different multiple for each comparable.
The selection of where within the range the appropriate multiple falls
requires judgment, considering factors specific to the measurement
(qualitative and quantitative).
14
Guideline Public Company Methodology
Are there any reasonably “comparable” companies in the
public marketplace?




Scope of services
Size
Profitability
History
Calculate multiples of: Revenue, EBITDA, EBIT
Adjust multiples for risk factors
15
Transaction (M&A) Methodology
Research transactions involving comparable companies:
• SEC filings
• Subscription databases
Compare target companies to subject company
Calculate multiples of: Revenue, EBITDA, EBIT
Adjust multiples for risk factors
16
Market Approach - Fundamentals
 The market approach reflects values from active markets that are
considered the most reliable measure of fair value at the valuation
date. These market values may require adjustments to reflect
restrictions on the ability to sell in the active market or access these
markets and the purchase of a controlling interest that may require
reflecting a premium over the active market price.
 The use of multiples of earnings and various forms of earnings, such
as EBITDA and EBIT, and sales multiples are all part of the market
approach.
The market approach relies on the ability to find assets and
liabilities that are sufficiently similar to rely on these multiples.
17
Income Approach
The income approach uses valuation techniques to convert future
amounts (for example cash flows or earnings) to a single present
amount (discounted). The measurement is based on the value
indicated by current market expectations about those future amounts.
Income valuation techniques include present value techniques:
• Option-pricing models, Black-Scholes-Merton formula (a closedform model) and a binomial model (a lattice model).
• The multi-period excess earnings method, which is used to
measure the fair value of certain intangible assets
18
Discounted Cash Flow Method
Dependent on the development of reasonable, achievable
cash flow projections:
–
–
–
–
–
How far out to take the projections?
Revenue growth rates
“Normalized” expense levels
Income taxes
Non-cash items
• Working capital additions
• Capital Expenditures
• Depreciation/Amortization
– Discount rate
19
Cost Approach
The cost approach is based on the amount that currently would be
required to replace the service capacity of an asset (current
replacement cost). From the perspective of a market participant
(seller), the price that would be received for the asset is
determined based on the cost to a market participant (buyer) to
acquire or construct a substitute asset of comparable utility,
adjusted for obsolescence. Obsolescence encompasses physical
deterioration, functional (technological), and economic (external)
obsolescence.
20
Valuation Inputs
Inputs refer broadly to the assumptions that market
participants would use in pricing the asset or liability,
including assumptions about risk.
SFAS 157 allows two types of Inputs:
1. Observable Inputs
2. Unobservable Inputs
21
Valuation Inputs
• Observable inputs are inputs that reflect the assumptions
market participants would use in pricing the asset or
liability developed based on market data obtained from
sources independent of the reporting entity.
• Unobservable inputs are inputs that reflect the reporting
entity's own assumptions about the assumptions
market participants would use in pricing the asset or
liability developed based on the best information
available in the circumstances.
22
Valuation Inputs
SFAS 157 emphasizes that a reporting entity’s valuation
technique for measuring fair value should maximize
observable inputs and minimize unobservable inputs,
regardless of whether the reporting entity is using the
market approach, income approach, or cost approach.
Inputs include price information, volatility factors, specific
and broad credit data, liquidity, and all other factors that
effect the fair value measurement.
23
Characteristics of Observable and Market-Based Data
OBSERVABLE
MARKET-BASED
Not proprietary
Reliable
Readily available
Based on a consensus within
reasonably narrow observable ranges
Regularly distributed
Provided by sources who are actively
involved in the relevant market
Multiple independent sources
Supported by actual market
transactions
Transparent & Verifiable
24
Accounting for
Mergers and Acquisitions
25
Accounting for M&A ASC 805 (SFAS 141R)
• COST ACCUMULATION – Historical Approach
Previously accounting for a business combination involves accumulating
costs of acquiring a target entity and allocating those costs to individual
assets acquired and liabilities assumed.
• ACQUISITION METHOD
•
The FASB and the IASB in ASC 805 determined that because a business
combination is a transaction in which an entity (the acquirer) takes control of
another entity (the target), the fair value of the underlying exchange
transaction should be used to establish a new accounting basis of the
acquired entity.
The acquirer should recognize and measure the assets acquired and
liabilities assumed at their full fair values as of the date control is obtained,
regardless of the percentage ownership in the acquiree or how the acquisition
was achieved.
26
The Acquisition Method
Applying the acquisition method requires each of the
following steps:
1. Identifying the acquirer
2. Determining the acquisition date
3. Recognizing and measuring the identifiable assets acquired, the
liabilities assumed, and any noncontrolling interest in the acquiree;
and
4. Recognizing and measuring goodwill or a gain from a bargain
purchase.
27
Measurement Concepts
ASC 805 Focus is on the Intangibles
The implementation guidance in ASC 805 includes a listing of examples
of intangible assets that the FASB believes meet the criteria for
recognition apart from goodwill and provides guidance in applying the
recognition criteria.
The FASB and the SEC staff expect this list to be used effectively as a
checklist such that, if an intangible asset that appears on the list exists
among the assets acquired in a business combination and is material, it
should be measured and recognized apart from goodwill.
28
Intangible Assets Typically Recognized
Marketing-related intangible assets:
• Trademarks, trade names, service marks, collective
marks, certification marks
• Trade dress (colors, shape, package design)
• Newspaper mastheads
• Internet domain names
• Noncompetition agreements
29
Intangible Assets Typically Recognized
Customer-related intangible assets:
•
•
•
•
Customer lists
Order or production backlog
Customer contracts and related customer relationships
Non-contractual customer relationships
30
Intangible Assets Typically Recognized
Contract-based intangible assets:
• Licensing, royalty, standstill agreements
• Advertising, construction, management, service, or
supply contracts
• Lease agreements
• Construction permits
• Franchise agreements
31
Intangible Assets Typically Recognized
Technology-based intangible assets:
•
•
•
•
•
Patented technology
Computer software and mask works
Unpatented technology
Databases
Trade secrets, such as secret formulas, processes,
recipes
32
Measurement Concepts
Assets that the Acquirer Does Not Intend to Use or
Utilize to its Highest and Best Use
Prior to SFAS 157, it was acceptable to use entity-specific
assumptions to value assets that were going to be abandoned or
not fully utilized, often resulting in either a transitional value or
nominal value.
ASC 805 requires all assets to be measured at fair value from a
market participant‘s perspective, without regard to acquirer
intent.
33
Measurement Concepts
Defensive Intangible Assets
Include assets that the acquirer will never actively use, as well as assets
that will be actively used by the acquirer only during a transition period.
Examples of defensive intangible assets include brand names and
trademarks. When determining the fair value of defensive intangible
assets, an acquirer should utilize market participant assumptions, not
acquirer-specific assumptions.
The requirement to apply the concepts of Fair Value to assets that
an acquirer does not intend to fully utilize can raise questions
regarding “Day 2” accounting for the assets.
34
Measurement Concepts
Non-competition Agreements:
To Value or Not to Value?
A non-compete agreement negotiated as part of a business combination
will typically be initiated by the acquirer to protect the interests of the
acquirer and the combined entity.
Transactions are to be treated separately if they are entered into by or
on behalf of the acquirer or primarily for the benefit of the acquirer. As
such, non-compete agreements negotiated as part of a business
combination should generally be accounted for as transactions separate
from the business combination.
35
Measurement Concepts
Property, Plant and Equipment
Fair value should be based on the value of comparable new property,
plant and equipment, less depreciation and obsolescence (i.e., decreases
in value due to physical depreciation, functional obsolescence or
economic obsolescence).
The recorded carrying amount of the asset should be the net value.
36
Measurement Concepts
Overlapping Customers – What’s the Value?
The SEC staff’s view, an acquired customer relationship that overlaps an
existing customer relationship has value because the acquirer, as a
result of the acquisition, has the ability to generate incremental cash
flows, such as the ability to sell new products to the customer and/or to
increase its “shelf space” with the customer.
However, as discussed at the 2006 AICPA National Conference on
Current SEC and PCAOB Developments, that value may appropriately
be reflected in the recognition of other intangible assets, such as trade
names or proprietary technologies that drive customer loyalty.
37
Measurement Concepts
Accounting for Research and Development Assets
(IPR&D) Changes…Again!!
Acquired in-process research and development (IPR&D) assets are not
permitted to be written-off upon acquisition, as has been required for
acquired IPR&D without an alternative future use by Statement 141 and
FIN 4.
Examples of IPR&D assets include patents, blueprints, formulae and
designs associated with a specific IPR&D project and the associated
values derived from productive results of target company R&D activities
conducted before the acquisition.
38
Measurement Concepts
In-Process Research and Development
IPR&D is used to describe research and development projects, not
products or processes already in service or being sold.
However, it is not amortized as it is not yet ready for use.
It is tested annually for impairment or when there are indicators of
impairment. IPR&D assets are tested separately for impairment as they
do not yet produce cash flows.
39
Measurement Concepts
Bargain Purchase
In rare circumstances the fair value of consideration transferred for an acquirer’s
interest in a business is less than the fair value of the net assets acquired,
resulting in a gain to the acquiring entity.
A gain is recognized for (a) the amount by which the acquisition-date fair value of
the identifiable net assets acquired exceeds (b) the acquisition-date fair value of
the acquirer’s interest in the acquiree plus the recognized amount of any noncontrolling interest in the acquiree.
Any such gain should not be classified as extraordinary, and is recognized
only after a thorough reassessment of all elements of the accounting for the
acquisition.
In previous practice, certain long-lived assets were reduced to zero before an
extraordinary gain could be recognized.
40
THANK YOU!
Keith C. Peterka, CPA
[email protected]
610.862.2744
Timothy Woods, CPA, MBA
[email protected]
720.200.7043
41
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